Fair versus Biased Valuations: The SEC Has Yet to Reach the Tough Cases
The Securities and Exchange Commission is on a mission to hold money managers accountable for the valuation of assets, particularly illiquid assets. Typically public equities and most bonds don’t pose a problem because money managers can obtain current market prices or multiple quotes from brokers. However, a wide range of assets trade infrequently or don’t trade at all. Nonetheless, money managers are expected to price these assets on a periodic basis. For example, a mutual fund that owns highly illiquid mortgage backed securities must price those securities every day even though those securities haven’t traded. A private equity or real estate fund is expected to value its holdings quarterly as it reports performance to its investors.
|Small Cap Due Diligence (2002)|
There is no doubt that the SEC is honing in on valuation practices across the entire spectrum of asset classes. A couple of weeks ago, I wrote about a private equity fund of fund that had mispriced its largest holding in order to report a return of 38.3% instead of the more accurate return of 3.8% (“Valuing Private Equity Assets: One Step Forward, Two Steps Back [March 13, 2013]”). The SEC brought an enforcement action against and settled the matter with Oppenheimer. The Commission has also brought cases against hedge funds, including Yorkville Advisors and KCAP Financial.
Mutual fund directors aren’t immune from the SEC’s scrutiny over pricing. Last December, the independent directors of Morgan Keegan’s mutual fund complex were charged with failing to supervise the pricing of subprime mortgages held by one of the complex’s mutual funds. The SEC has already settled with Morgan Keegan for $200 million and the portfolio manager accepted a lifetime ban from the industry. According to The Wall Street Journal, the SEC and the directors are in settlement discussions as an April 2 hearing approaches.
As the Journal points out, the directors met frequently as the credit crisis unfolded. Apparently they also asked lots of questions. However, they failed to take note of the fact the prices of the subprime mortgages held by the mutual fund weren’t changing, despite the deterioration of the credit markets. Mutual fund directors have a specific responsibility to review the pricing of illiquid securities: hence, the SEC’s enforcement action.
Is the SEC going too far? Will prospective directors shy away from mutual fund boards because of the scrutiny? Will fund expenses rise as a result of these actions? In my view the answers are “no”, “no”, and “yes.” I think the SEC should press directors to perform their duties. In the Morgan Keegan case, the SEC is simply saying that the directors should have taken notice of stale prices. They aren’t intimating that the directors should have made an independent assessment of the value of the subprime mortgages.
The available pool of mutual fund directors won’t dry up. After the mutual fund scandals unearthed by the New York State Attorney General about ten years ago, critics warned that the burdens placed on mutual fund directors would sharply limit the supply of candidates. As a result of various SEC rulemakings, mutual fund board meetings became more frequent and longer, and the board materials became voluminous. Nonetheless, money managers found plenty of folks willing to serve on boards.
Fund expenses will probably rise, albeit by a tiny amount in comparison to management fees, marketing expenses, and trading costs. Lawyers and accountants will probably bill for a few more hours of work, and insurers may increase rates a bit for directors and officers (D&O) insurance.
The Morgan Keegan and Oppenheimer cases are relatively easy because the mispricing of assets was blatant. At some point, the SEC will confront the more subtle aspects of valuing illiquid assets. Establishing the estimated price for a private company or real estate asset requires a host of assumptions and judgments about future cash flows, discount rates, comparable assets, and related metrics. At the end of the valuation exercise, the price is only an estimate surrounded by a great deal of uncertainty. However, in the hands of an unscrupulous manager, these assumptions can be manipulated to produce extremely biased price estimates that only serve to mislead investors. In my view biased valuations are a far greater, albeit subtler, problem than the blatant misrepresentations illustrated by Morgan Keegan and Oppenheimer cases.
The real question is whether the SEC can develop and retain the professional expertise necessary to separate good faith from biased estimates of value. Most investors are incapable of divining the difference, and I don’t think the SEC will be any more successful. Dodgy money managers have a virtually insurmountable advantage in both expertise and resources. As a result, the SEC will probably wind up ensnaring as many honest, if imperfect, valuations, as dishonest ones.